The incidence of covenant breaches, requests for waivers, and related restructurings of loans to highly-leveraged companies in Europe has accelerated over the past year. And as much of Europe enters into recession and private equity companies are no longer able to justify supporting portfolio companies with new equity, the financing difficulties being experienced by speculative-grade companies are likely to intensify.
From its portfolio of 800 speculative-grade industrial companies in Europe, for the 12 months to October 30, 2008, S&P identified 38 covenant breaches, waiver requests, or related restructurings, compared with 18 in the previous 12 months.
In addition, the number of companies experiencing covenant difficulties within three years of their last financing has increased to 29 in 2007 and 23 in 2008 year-to-date, from four in 2006.
In total, 64 companies experienced covenant problems during 2006, 2007, and so far in 2008. Of these, 48% were covenant breaches, 34% were waivers or covenant resets prior to an actual breach, 3% were equity cures to avoid breaches, and 14% were financial restructurings related to any of the previous.
The common theme for these companies has been weak operating performance. When private equity purchased portfolio companies during the boom years, many predicted aggressive and steady EBITDA growth rates, helping to justify high purchase multiples.
But the turbulence in the economic environment since the liquidity crunch began has made meeting these projections very difficult, particularly for companies operating in sectors dependent on consumer demand or in highly cyclical or seasonal businesses.
Rising raw material prices also affected many companies during 2007 and most of 2008, mainly because damaged liquidity positions increased their need for working capital. Vulnerable companies, if un-hedged, may now be aided by the fact that raw material prices are declining again. However, a drop in demand due to the worsening economic environment may cancel out any cost savings.
Separately, there appear to be problems in the gaming and leisure sector from specific regulatory risks, independent from the cyclical downturn. Most of the companies in this category were hit by a drop in demand due to the smoking ban in the UK, which affected their earnings growth.
All the companies with covenant problems operate in a variety of sectors, encompassing 26 industries in all. Some of the sectors typically considered to be cyclical were present as expected, such as retail (9%), construction (5%), autos (9%), chemicals (8%), containers or packaging (6%), food industries (9%), and home furnishings (5%).
These concentrations are generally higher than the sectors’ respective share of total issuance in the European market as a whole, indicating that covenant problems are not necessarily correlated to high debt issuance levels.
For example, in the 12 months to June 2007, retail comprised only 6.7% of the new-issue market while chemicals made up 4.1%, according to Standard & Poor’s Leveraged Commentary and Data (LCD).
Surprisingly, telecommunications, which typically is considered a defensive sector, represented 5% of the companies experiencing trouble, indicating the range of industries with difficulties. Other sectors usually considered to be stable, such as electrics, consumer non-durables, cable, and beverage and tobacco were also present in the group of companies with covenant problems.
Meanwhile, cash injections by private equity appear to be rising. During 2008, the number of transactions where private equity owners injected new equity in response to a breach, covenant waiver, or reset increased to 11 out of 24 deals, or 46%. This was up from 33% in 2007, and 20% in 2006.
Financial sponsors may be injecting new equity in order to buy time while raising funds. In some cases, they might still see value in a particular business, or they may be waiting to see how difficult market conditions become. Also, in the past banks may have been more lenient and agreed to waivers or resets without asking for equity.
In the future, however, if sponsors have already taken equity out of a company through a dividend recapitalization and have made a return on their original equity, they may be less likely to put new funds to work, particularly if they see no potential for future returns.
Surprisingly, of the companies examined that experienced difficulties over the last three years, only 3% had been through a recapitalization. This could be because those companies that were able to recapitalize their debt structures were typically stronger financially, and so were at less risk of a breach.
However, since a recapitalization usually results in a much more highly leveraged structure, these newly recapitalized companies may now be more likely to experience covenant breaches than before the recapitalization. Furthermore, there has been no lack in overall recapitalizations in the past few years. In 2006 and 2007, these transactions made up 21% and 17% of newly syndicated transactions, respectively, according to LCD.
The acceleration in companies breaching covenants or needing resets is indicative of the very difficult economic conditions that highly leveraged companies are facing. In our view, the next two to three years will be very difficult for investors in this asset class as not only breaches, but defaults, accelerate as well.